Conflicts Of Interest: The Manager Got Your Money

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 |  Includes: AGNC, CMO, HTS, IVR, OAKS, PMT
by: ColoradoWealthManagementFund

Summary

Conflicts of interest are very common in REITs.

The costs of agency are reducing returns to shareholders.

Shareholders should know which conflicts are present in their investment.

Conflicts of interest have become common in America. Sometimes those conflicts of interest create huge disasters like Enron. However, investors often encounter much milder effects from the conflict of interest. There are multiple ways to analyze Real Estate Investment Trusts (REITs), but they are not complete without a recognition of the agency costs those REITs will encounter. Fortunately, many of the agency costs fall under mandatory disclosures, so it is possible to sift through the financial statements for a REIT and discover which conflicts they are facing. However, for an individual investor, the cost of sifting through every document for every possible investment would be horrible. Not only are there are tons of REITs and several different conflicts of interest, they are often disclosed in different ways.

The companies being analyzed here are AGNC, OAKS, HTS, IVR, PMT and CMO.

10-K links: AGNC OAKS HTS IVR PMT CMO
For CMO, you'll also want their "Definitive Proxy Statements".

Below, you will see a chart showing several of the most common conflicts of interest, in shorthand, on the Y axis. Above the X-axis will be the ticker symbol for several REITs. This list is far from exhaustive. At present, six REITs have been included. If the list is popular, it will be expanded and updated with more REITs and more conflicts of interest.

Click to enlarge

Green squares represent a conflict of interest that is not present.

Yellow squares fill the places where it could not be determined if the conflict of interest was present.

Red squares represent a conflict of interest that is present.

Numbers/Letters: These tell you where to go in the financial statements to find out more about a conflict, lack of a conflict, or see what inconclusive evidence has been discovered.

An empty cell means nothing was found on the topic. Only Yellow squares can be blank. If a conflict is clearly present, or not present, there will be a source.

How to read the numbers: The most common thing to find in a cell is #-K. The number represents the page number. The K is indicating that the appropriate document is the 10-K for the company. F-#-K is not an expletive, though it might feel that way after hours of reading statements. F-27-K would refer to page "F-27" of the most recent 10-K for that REIT. For your convenience, links to each document on the SEC website will be provided.

The first six REITs all contained measures that effectively created golden parachutes, regardless of how those policies were presented. "3* annual 8-K" means the value of the golden parachute is equal to 3 times the annual management expense, and more information can be found on page 8 of that REIT's 10-K.

CEO/Chairman: This line is for flagging when the CEO is also the chairman of the board. The board of directors is responsible for representing the shareholder's interest. The CEO is interested in having the highest salary possible, and it is the duty of the board of directors to limit compensation. Therefore, these positions should be at odds.

Often times the CEO may move into an external manager structure. In that case, he might cease to officially be the CEO. The conflict of interest does not disappear though, so it is still flagged. Any time the primary decision maker(s) is able to determine how much to pay himself/herself/themselves this conflict is present. The specific titles of "CEO" and "Chairman" are not required.

External manager structure: This is a structure in which the decision maker for the firm is not directly employed by the firm. It is referenced as a conflict of interest because it CAN strengthen management's position at the expense of shareholders. This area may merit an entire article at a later date.

Not arm's length: If the contract for compensation was not an arm's length transaction, it may have several factors that are not favorable to shareholders.

Golden parachutes: Any kind of payout to people upon their disassociation with the company will be flagged here. Regardless of the reason for the payout, payments to people who are no longer affiliated with the company represent expenses. Because many REITs are externally managed, this will often be a payment to the management company, rather than to the individual. However, the management company may be beneficially owned by the former CEO. Some payments might not meet the legal definition of "Golden Parachutes," but they have a similar effect. When the executive leaves, he (or she) legally takes the shareholders' money with him or her.

Equity based compensation: This simply refers to the presence of a payment from the REIT to the manager that does not require adequate performance on the part of the manager. It is largely a fixed cost, which has two negative implications.

  1. As a fixed cost, it will not decrease if revenues go down. This increases variance in revenues.
  2. If the manager is incapable or unwilling to invest the personal resources required to earn risk adjusted returns, they will still receive all or a significant part of this payment.
  3. Share buybacks, even at a discount to book value, will reduce the book value of equity. Managers may choose to ignore attractive opportunities to enhance their pay.

Adjusted "Equity" definition: It is common for REITs to use a definition of equity that differs from the common definition. One of the most common effects is to exclude changes in "Accumulated Other Comprehensive Income." When there is a large loss in Accumulated Other Comprehensive Income, the manager may refuse to sell the security even if doing so would be in the best interest of shareholders.

Indemnification: Indemnification means the REIT has excused management from any wrong doing. Generally there are limits under the law about what can be excused. However, when this is combined with the CEO/Chairman conflict, it means the manager (on behalf of the shareholders) has excused himself from any liability to the shareholders.

Other employment is permitted: This means the executives, employees, or managers of the company are not restricted from seeking and obtaining employment with another firm while working for the REIT in question.

No meaningful restrictions on employment: This means there is a distinct absence of any precise limitations that would protect the shareholders. Some examples of a "Meaningful" restriction:

  1. The manager is required to work at least 15 hours per week on the interests of the REIT.
  2. The manager is not permitted to work for another company in the same industry at the same time.
  3. The manager's firm, or parent firm, is restricted from sponsoring another entity that would compete with the REIT.

If this square was red then it appears no restrictions are present.

Competing employment is currently happening: This is a very dangerous conflict of interest. This means that the managers (or a company they are affiliated with) are engaging in activities that could damage the success of the REIT. For example: The REIT might have an external manager structure. The management company then may have two (or more) REITs that are clients. The manager within the company may have to allocate trades between the two accounts. Some trades may be better than others. The manager might have a compensation structure in which they are lucratively rewarded for assigning the most profitable trades to the other REIT.

Conclusion: There are no stock recommendations here. No advocating for one company or another. The only recommendation is that each investor should become aware of the conflicts of interest that are common in the industry. This list is NOT exhaustive.

Despite conflicts of interest, it is possible for managers to fulfill their duty to shareholders. From the chart, it appears AGNC has several conflicts of interest. They are receiving payments based on equity, but have aggressively been repurchasing shares when they were trading at a discount to book value. In that decision, it appears they decided to act in the shareholders' interest instead of their own. A conflict of interest doesn't mean a company is not viable as an investment. It does mean more due diligence is required.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.